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How Paying Just the Minimum on Your Credit Card is a Trap

NEW YORK (MainStreet) —Remember what they say about corporate financial statements? That they are like bikinis: they reveal the essential but conceal the vital. Well, your credit card statement is a bit like that too. It tells you how much you spent and what you ought to pay, but puts all the information about interest and fees in the fine print, a place you’ll never look. Unfortunately, that’s where the devil lies. And here’s one such devil.

The minimum amount trap

“I used to pay only the minimum on my credit card,” a colleague once told me. “And in a few months I had piled on substantial debt that included a big interest component." He thought that's what the credit card company wanted him to do, and he learned the hard way.

See also:Budget Tips for New Grads

The minimum amount is usually around 2% of the total outstanding that you must pay each month to avoid a late fee. But what most people overlook is that paying only the minimum will still attract a hefty interest on the rest of the balance, including on any new purchases, that too on a compounded basis.

The numbers can be quite eye-popping. On a moderate credit card outstanding of $1,500, if you made only the minimum payment each month without adding anymore debt, it could take you up to 11 years to repay the entire amount at an interest rate of 15%. You would be paying a total interest of $1,413. If your balance was $5,000, you would be making repayments for 24 years and shelling out $7,246 in interest alone. Now if you also keep adding new debt, you will find yourself in a nasty situation.

Thanks to the Credit Card Accountability, Responsibility, and Disclosure Act (CARD Act) of 2009, you can now find these numbers on your own credit card statement every month. The act requires issuers to include an information box on credit card statements showing how long it would take to pay off the balance on the card by making only the minimum payment. “When they see the numbers, a lot of people think it’s a mathematical error," said John Ulzheimer, President of Consumer Education at SmartCredit.com. "With a car loan or a home mortgage, you know right from the start how long it will take to pay off. But with a credit card, people don’t believe the debt can pile up like that.”

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Unfortunately, while this information has indeed been a revelation, data shows that the percentage of people who carry credit card debt from month to month continues to be high. According to the National Foundation of Credit Counseling’s 2013 Consumer Financial Literacy Survey, 37% of households carry credit card debt from month to month. This is not significantly lower than 2010 when it was 41%.

Benefits of paying more than just the minimum

So if you’re among those who habitually carry debt on your credit card, here’s why you should pay much more than just the minimum each month:

1)You can save on interest costs

 

“The average interest rate on credit card debt today is around 15%, and that is likely the most expensive debt you will carry,” Ulzheimer said.

Like we saw in the example above, on a moderate credit card with $1,500 outstanding, you could be paying a total interest of $1,413 over 11 years. Now, instead of paying only the minimum each month, if you paid a little more, say $40 regularly each month, you could pay off your debt in 4 years at a total interest cost of $537. You can use this calculator to check out your own payoff status.

“Moreover, according to the CARD Act, any sum that you pay over and above the minimum payment would be applied to your most expensive debt,” Ulzheimer explained. This means if you have accumulated various debts at different rates of interest, paying more than the minimum will help you exhaust the most expensive debts first.

2.You can build better credit history

Your credit history is impacted by how much of your total credit you utilize or how close your outstanding balance is to your limit. “The only thing that matters is your balance," Ulzheimer explained. "It does not matter whether you built up the balance through purchases or interest costs and fees. The closer you are to your credit limit, the more it will negatively impact your credit score.”

“Like it or not, we live in a credit dominated society," said Gail Cunningham, a spokesperson for the National Foundation of Credit Counseling. "Although most people can live on a cash basis for daily needs, they will need a thick and positive credit file when it’s time to buy a house or a car. Therefore, a young adult is wise to protect their credit by paying responsibly and not utilizing more than 30% of their available credit.”

The ideal monthly payoff

In a perfect world, a person would pay off 100% of the bill each month. Short of that, Cunningham believes they need to commit to paying off any balance within three months. “This involves stopping charging, as in adding debt to an account where a balance is carried," she said. "This is not only counter to the objective, but results in paying interest on the interest.”

“I think you must take an extraordinary effort in your financial life to take control of your credit card debts. When the interest rate on a savings account is less than 1%, credit card interest far exceeds any value of leaving that money dormant,” Ulzheimer concluded.

See also:Why is Credit Card Use Increasing?

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